First off, I am not a CPA—or even a tax attorney. However, a large number of potential clients who visit me to inquire about the advantages of bankruptcy relative to those of a short sale (or outright foreclosure walk-away) when distressed real estate is their primary concern have not realized that there may be tax-related disadvantages to the short sale of a property or walking away via foreclosure.
Indeed, there can be.
Generally speaking, a surrender of underwater or already-foreclosed real estate in the bankruptcy process is a quicker, more cost-effective, and more protective way to walk away from a distressed home without fear of future collections or tax liability than a short sale—and certainly a foreclosure (in Michigan, unless your home is worth more than you owe on it, you cannot simply walk away from a home and let the bank foreclose upon it without opening yourself up to collections efforts for the deficient difference between what the house sells for at a foreclosure sheriff’s sale and what you own on the terms of your mortgage note).
One of the primary reasons that bankruptcy is a superior way to let a home go than a short sale, despite is negative reputation, is that there are no tax consequences to the surrender of a home or piece of real property in bankruptcy, particularly not a home that is your primary residence.
When you file for bankruptcy, you are legally insolvent. That being the case, there are no taxable consequences resulting from the discharge of debt or from the surrender of property in bankruptcy.
Outside of bankruptcy, there are various possibilities for the arising of taxable consequence to the surrender or short sale of property.
If a house is sold for less than is owed under the terms of the mortgage note that the home secures, there will be a “deficiency” resulting from the sale. Thus, the term “short sale” … Home sold for an amount short of what is owed for it. In some short sale deals, the lenders holding or servicing the note may agree to refrain from collecting upon the deficiency (that is, coming after you for it!) as part of the short sale negotiation. (A bad short sale deal involves NO guarantee of protection from collections—and there are many of these out there!) If there is a 2nd or 3rd mortgage on the home (yes, a home equity line of credit is a type of mortgage), it is even more vital and more difficult to obtain such guarantees.
However, even if these guaranties are delivered and acted upon properly by the involved banks or lenders or investors, the deficiency debt resulting from the short sale will almost certainly still be charged off by the holder of the mortgage note(s). That is, the debt will be reported to the IRS as lost business income by the holder of the debt, and they will gain a tax benefit to their bottom-line as a result, but you will be required to pay taxes as if the charged-off debt were personal income that you earned by way of working as a contract employee for that creditor in that year. This is because “charged-off” debt is treated by the IRS as “forgiven debt,” and “forgiven debt” is considered by the IRS to be a form of personal income.
In other words, you will receive a 1099 form from the creditor for the amount of the deficiency that you will have to then pay taxes on, unless you are eligible for forgiveness under the Mortgage Debt Relief Act, which expires at the end of this year unless renewed by Congress, or some other definitional insolvency standard.
There can be additional tax implications beyond this basic charge-off situation as well. For instance, if the real estate involved is a personal residence but not your primary personal residence or if it is commercial real property, there can be capital gain income or “prior depreciation recapture” income that is treated for taxable purposes like personal income. (Note that taxes owed that are less than 3 years old are not dischargeable in bankruptcy and may not be dischargeable at all depending upon other considerations as well!)
The amount of “personal income” that is taxable resulting from the loss of real estate can be considerable, often more than a person actually earns in a year from their own, real jobs since so many mortgages were so artificially huge at the height of the real estate bubble and since so many of them were so irresponsibly lent.
If you are considering a short sale and this is of concern to you, it is essential that you examine the tax-protective option of bankruptcy before committing to short sale deal, regardless of how ardent your real estate broker is about the benefits. If for not other reason than, although must people think of a Chapter 7 surrender of a home when they think of bankruptcy, there is the additional option of stripping a 2nd or 3rd mortgage in order to save a home and make it worth keeping that is availabe in a Chapter 13 bankruptcy.
If you are a southeast Michigan resident and are considering filing for bankruptcy, please feel free to contact me at firstname.lastname@example.org or (866) 674-2317 to schedule a free, initial consultation.